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IEA warns against Coalition policy on Capital Gains Tax

Philip Booth Philip Booth, Editorial and Programme Director of the Institute of Economic Affairs warns against Coalition policy on CGT.

Organising a coalition agreement is never easy. There has to be give and take on both sides. However, the Conservatives have made a big mistake in accepting some aspects of Lib Dem tax policy - especially in the area of Capital Gains Tax (CGT). The tax is seriously misconceived and raises little revenue, it can however, do much economic harm.

It is likely that there will be exemptions for so-called business assets and for business activities that the government regards as entrepreneurial. But these distinctions are arbitrary. If I had invested in Microsoft shares when it was a small fledgling company, why should that investment be treated differently from the investments of an owner-entrepreneur? Like Inheritance Tax, CGT will create an industry of avoidance techniques and spurious business capital structures that are simply designed to avoid the tax. Nice work for tax lawyers.

But the really pernicious aspect of CGT is that it is generally a double tax. We think of capital gains enriching somebody as if they arise like manna from heaven - and therefore are worthy of being taxed. But investments are valued for the income they produce. The values of investments fluctuate up and down, but investments only go up in value in a sustained way when investors expect them to be more profitable in the long term. Those profits, of course, will be taxed when they are earned.

Two groups of people will be particularly affected by this change. The first are those investing in the buy-to-let market (people who own second holiday homes are pretty good at avoiding the tax altogether). If a landlord owns half a dozen homes and rents them out to students, he already pays tax on the rent he receives. If the values of the properties go up he may, in the future, have to pay 50% capital gains tax on the increase in value. This could be crippling for small landlords or for people who use a second home to supplement state pension income - who will also be clobbered by Inheritance Tax when they die. Why do house prices rise? Mainly for two reasons. The first is because of inflation - and it is iniquitous to tax people on gains that only arise because of the inflation that the government has itself created. Secondly, house values rise because of increased demand for housing or because of supply constraints that tighten the market and lead rents to rise over the long term - a feature of the UK housing market for a couple of generations. When those rents eventually accrue to the landlord, he will pay tax on them. Taxing the landlord also on the rise in the value of the houses is double taxation and bordering on confiscation.

Recent governments have tried hard to liberalise the rented housing market - though the last government threw some sand in the wheels. This proposed move on CGT threatens to send us back to the dismal days of the 1980s.

A similar situation arises for the owners of shares. George Osborne thinks that returns to debt finance for companies are under-taxed and has spoken about removing some of the apparent "reliefs" on debt finance. In fact, debt finance for companies is taxed exactly how it should be. It is equity finance that is penally taxed due to the high rates of corporation tax and the fact that corporation tax cannot be reclaimed by non taxpayers. Now the government proposes a "double whammy". When companies retain profits for future investments, the share price tends to go up. When investors expect a company to make better profits in the future, its price also increases. But these profits are taxed already (at a penal rate). To then tax shareholders on the capital gains that arise from an increase in the price of an asset is to add yet further to the tax burden. Of course, share prices fluctuate in the short term for all sorts of reasons, but a sustained rise in a company's share price can only happen if the company has retained profits or if investors expect better profits in the future. To tax those profits and then tax the capital gain is unjustifiable double taxation.

It is beginning to dawn on people that one of the reasons for the financial crash was the foolish over-taxation of equity finance that exists in nearly every developed country. It gives incentives to companies to load themselves with debt and create complex financial engineering instruments. It may not have been the main cause of the crash but the instinctive dislike that governments have for "profits" and the way they treat profits in the tax system needs to be reformed. The coalition wishes to move in the opposite direction.

CGT can also bring lots of unseen consequences. Because it is only charged on a disposal of an asset, investors are put off selling at the best time for them and try to engineer sales to offset gains against losses. All this costs investors a lot of money. But it also costs the government money. There is every danger that a sharp rise in the rate of CGT could bring about widespread avoidance techniques that actually lower the yield.

It has to be said, that there are some justifications for a CGT. The most obvious one arises where investors try to hide income as capital gains so that investment returns are taxed at a lower rate of tax - some have suggested that this is a problem in the private equity industry. It may be that this needs looking at. However, HMRC already have plenty of powers - and they can be extended - to make sure that income is taxed as it should be, even when it is disguised as a capital gain.

As it is, this proposal to increase capital gains tax is deeply flawed. It is a kick in the teeth for savers; it is a kick in the teeth for those who cannot afford to avoid it; and it is a kick in the teeth for companies that do not load themselves with debt. The effects on the private rented market could be most regrettable. Why anybody should want to bias the tax system further in favour of debt financing in the wake of the financial crash is a mystery to me and why anybody should want to tax savings and investment yet further, as we recover from the lowest savings ratio in history, is completely baffling.


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